Opportunity and risk, according to Oaktree
Oaktree has applied the microscope to the credit markets in its latest Performing Credit Quarterly report for the fourth quarter of last year. Here’s a summary of five of the firm’s observations:

1. Defaults and volatility up: In 2022, interest rate risk was the major driver of relative performance in fixed income, with floating rate outperforming fixed rate. But this is a situation likely to change if we see a slowing of major economies. With only a small percentage of loans maturing before year end, near-term default risk is low but rising. Oaktree predicts “significant volatility and dispersion based on quality”.

2. A void at the larger end: With banks seeking to reduce balance sheet risk, they have little appetite to underwrite large-scale financings for leveraged buyouts and M&A. Private debt funds with sufficient capital and flexibility are filling the void, attracted by larger average yield spreads than are typically found in traditional mid-market deals. Lenders are also now able to obtain significant investor protections.

3. Fixed-rate bonds offer relative value: With the possibility of investor focus shifting from interest rate risk to credit risk, investment-grade and high-yield bonds may become more attractive than loans as economies weaken. Bonds rated BB and higher offer “minimal credit risk, attractive yields and limited near-term maturities”. For lower-quality issuers, the outlook is much less optimistic.

4. “Junk loans” a concern: Given rising borrowing costs, high leverage ratios and eroding fundamentals, the outlook is challenging for leveraged loans going forward. The increase in downgrades in recent months is possibly the prelude to an increase in defaults, and these defaults could face lower than expected recoveries due to the prevalence of covenant-lite loans.

5. Opportunities for bargains: The report quotes Oaktree co-founder and co-chairman Howard Marks, who recently expressed the view that lenders and bargain hunters face much better prospects now than they did during the low-rate period from 2009 to 2021. He advises to be prepared for a change in strategic focus: “The investment strategies that worked best [over the past 13 and most of the last 40 years] may not be the ones that outperform in the years ahead.”

Varde views on what lies ahead
The latest Varde Views from fund manager Varde Partners presents three possible credit cycle scenarios, ranging from the mildly concerning to the deeply troubling.

The first of these sees a smooth deleveraging, modest growth forecasts and a rapid moderation in inflation. Although this sounds rosy enough, there will be a multi-year deleveraging cycle with “bumps in the road”, particularly where leverage is high and in segments of the credit market that are materially impacted.

The second would be a stagflation scenario with policy makers unable to stop inflation and growth continuing to slow. Here, corporates would be pushed into faster and more disorderly deleveraging and the strong economic environment of 2022 would be a thing of the past.

In the third scenario, a worse than expected recession would lead to more severe deflation than currently expected. This scenario is made more feasible by the Fed apparently favouring this outcome over sticky inflation. Mitigating against this outcome is the strength of labour markets around the world. Varde points out that deflationary deleveraging “tends to be relatively good for credit” due to eventual intervention by central banks.

Across all three outcomes, Varde says there is potential for distress and dispersion. Signals suggest that the severity of deleveraging is likely to be somewhere between the global financial crisis and that experienced in the 2015-16 cycle.

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